By Jesse Westbrook and Edgar Ortega
July 18 (Bloomberg) -- The U.S. Securities and Exchange Commission is poised to exempt market makers in stocks from an emergency rule aimed at preventing manipulation in shares of Fannie Mae, Freddie Mac and 17 Wall Street firms.
The agency's staff, after conference calls to discuss the rule that limits the ability of traders to use abusive tactics when betting on a drop in share prices, agreed to requests by exchanges and brokerages to modify the terms. Exchange officials had told regulators that without an exemption, market makers responsible for pairing off investor orders will struggle to keep transactions flowing and may raise costs for investors.
``The staff is recommending exceptions to the short-sale order for market makers of the 19 stocks and their derivatives from arranging to borrow in advance for short sales in their market-making and related hedging activities, to avoid constraining the market makers' provision of liquidity,'' SEC spokesman John Nester said in an e-mail from Washington. The full commission may vote as soon as today.
SEC Commissioner Christopher Cox, who announced the order July 15, is seeking to make it harder for traders to illegally drive down stocks of the two mortgage buyers and Wall Street firms and prevent another collapse like Bear Stearns Cos. The rule takes effect July 21.
Investors will be required to borrow stock that they plan to sell short as a bet on a decline in prices. Prior to the order, which applies to shares of Fannie Mae, Freddie Mac and 17 brokerages, investors were only required to locate shares that they had reason to believe were available for borrowing.
Options Exchanges
Options exchanges asked the SEC to ease the restriction for market makers, who rely on quickly shorting stocks to hedge their trades, said three people familiar with the matter who declined to be identified. Market makers must quote bids to buy and offers to sell contacts on their assigned stocks.
``Without a market-maker exemption, I could see this having a profoundly negative impact on the liquidity that would be provided in stock and derivatives,'' said Steve Sosnick, an equity risk manager in Greenwich, Connecticut, for Timber Hill LLC, one of the largest options market makers in the U.S. ``The SEC has to be very careful not to craft a rule that has undesirable impacts on liquidity in various sectors of the marketplace.''
In a short sale, an investor borrows and then sells the shares in anticipation of a price decline. If the trade works as planned, the investor is able to buy back the stock at a lower cost and return the shares to the lender, pocketing the difference as profit.
`Naked' Short Sales
Traders are sometimes unable to actually borrow the shares and complete a ``naked short-sale.'' If the loaned shares are never repaid, investors can sell more shares short than legally allowed and put pressure on a stocks' price.
Freddie Mac and Fannie Mae shares, the two largest mortgage lenders in the U.S., and Lehman Brothers Holdings Inc., the No. 4 securities firm, have lost more than 70 percent of their market value this year. Citigroup Inc., the largest bank by assets, has lost 43 percent; Merrill Lynch & Co., the No. 3 securities firm by market value, has lost 39 percent.
``They are certainly on the political hot seat, but this is their response and you have to give them the benefit of the doubt for the time being,'' Bill Brodsky, chairman of the Chicago Board Options Exchange, the largest U.S. options market, said in an interview July 16. ``I'm hopeful that it won't be that bad. Right now it's limited both on scope and timeframe and we'll continue to work with the SEC.''
Costs Rise
Options market makers engage in short selling to reduce the risk they assume when pairing off customer orders. Forcing them to pre-borrow the shorted shares could make it harder for them to trade, making it more expensive for investors, said Peter Bottini, a former CBOE market maker.
``The cost for customers to trade these products could go up dramatically,'' said Bottini, who is now executive vice president of Chicago-based online brokerage OptionsXpress Holdings Inc. ``Our customers are going to have a tougher time taking a bearish stance in these companies.''
To contact the reporter on this story: Edgar Ortega in New York at ebarrales@bloomberg.net.
Last Updated: July 18, 2008 00:01 EDT
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